NovaStar reports fourth-quarter loss

On Tuesday, February 20, NovaStar, a residential lender and mortgage real estate investment trust, announced loss of $14.4 million or 39 cents per share in the last quarter of 2006. A year earlier, the company reported earnings of $26.4 million, or 84 cents a share. In after-hour electronic trading NovaStar’s shares dropped 33% to $11.81.

Earnings for 2006 were $66.3 million, a remarkable 50% drop from $132.5 in 2005. Loan origination was up 20% in the fourth quarter of 2006, and 21% higher than 2005 levels for the entire year. NovaStar specializes in subprime mortgages and, as default rates increase, it is forced to repurchase the bad loans it sold to banks earlier. This type of problem is increasingly affecting subprime lenders, who loosened their underwriting guidelines in 2006, allowing the issuing of high-risk loans. Now that borrowers are defaulting, mortgage companies are forced to buy those loans back, suffering further loss and reducing earnings estimates.

So is NovaStar the next New Century? According to Scott Hartman, Chief Executive Officer at NovaStar, probably not. Even though the repurchase requests were at record levels in the fourth quarter of 2006, the company believes its cash and available liquidity of $154 million will cover the risk for all loans sold to date. To ensure better results in 2007, the company is tightening its underwriting guidelines, enhancing the appraisal review process and avoiding loans that carry “unacceptable levels of risk”

Nevertheless, next year’s dividend could fall to $4 from $5.60 in 2006. According to company officials, there may be little to no taxable income from 2007 through 2011. The management is currently evaluating whether it is in shareholders’ best interest to abandon the company’s REIT (real estate investment trust) status, given the restrictions it imposes on the company’s operations. For 2007, NovaStar believes it will meet the REIT distribution requirements of distributing at least 90% of undistributed 2006 taxable income.

This news may be a bitter pill to swallow for NovaStar investors, but it is not as bitter as the one New Century shareholders got. It seems the end of subprime lending, or at least a significant contraction, is near.